Derivatives traders and lawyers are focused on March 1. Not for any basketball tournaments, but for the variation margin (VM) big bang. From March 1, 2017, swap dealers and financial end-users will be required to exchange VM on uncleared swaps. To comply with the applicable VM rules, swaps dealers and financial end users will need to amend their derivatives documentation, including credit support annexes (CSAs). ISDA created the 2016 VM Protocol (the VM Protocol) to provide a documentation solution that complies with the U.S. banking prudential regulator and Commodity Futures Trading Commission (CFTC) VM rules, as well as similar rules in Canada, Japan and under European Market Infrastructure Regulation (EMIR). In addition to selecting the relevant jurisdictions required for compliance, counterparties can elect to:
- Amend existing master agreements to add new CSAs for VM on terms determined by the VM Protocol.
- Amend existing master agreements and CSAs to cover new transactions (but not trades entered into before March 1, 2017) by creating a replica of their existing CSA and then amending it to comply with the jurisdictions selected.
- Amend existing CSAs in order to comply with the jurisdictions selected (which would cover all transactions under the master agreements).
- Create new ISDA 2002 Master Agreements (using agreed-upon boilerplate terms) with new compliant CSAs.
While the VM Protocol is quite flexible and can satisfy applicable VM requirements in the US, Canada, Europe and Japan, many market participants have elected to not use the VM Protocol. Rather, many participants have decided to negotiate new or amended CSAs on a bilateral basis. Considering that it often takes months to negotiate a single CSA, and that thousands of counterparties will be required to exchange VM on March 1, derivatives lawyers for swap dealers and investment managers are working diligently to finish the new documentation in time.
But, What If…?
If a substantial number of counterparties have not executed bilateral compliant CSAs or adhered to the VM Protocol by March 1, they will not be able to trade uncleared swaps. This could disrupt global swap markets by reducing liquidity and increasing risk by preventing market participants from hedging existing positions. The easiest solution would be for the CFTC and other global regulators to postpone the March 1 deadline. Hong Kong and Singapore have already announced a six month phase-in period for counterparties to continue to negotiate compliant documentation. Australia has also postponed the deadline to September 1, so long as all transactions executed from March 1 are subject to VM requirements by September 1. Unfortunately, the European Commission may be unwilling or unable to push back the March 1 effective date for the EMIR VM standards. This could put acting CFTC Chairman Christopher Giancarlo in a difficult position. Chairman Giancarlo has emphasized the importance of harmonizing global derivatives regulation, particularly to prevent market fragmentation.
I am especially concerned that smaller firms, including American pension and retirement funds, may not be able to get their documentation done in time. If they do not, they will be abruptly forced to stop hedging their portfolios at a time of enormous changes in financial rates and global asset values.” – Acting CFTC Chairman Christopher Giancarlo
The CFTC could decide not to provide relief in order to maintain consistency with the EMIR VM standards. The CFTC elect to provide short-term transitional period of relief, much as it did on September 1, 2016 for large swap dealers to complete the custodial arrangements needed to comply with the initial margin requirements applicable to dealers (the 2016 Relief). However, the 2016 Relief was implemented at the last minute and offered only a 30-day period for a small number of dealers to complete less complex documentation. Given that the VM rules have a global impact and the upcoming March 1 deadline will affect a much larger set of counterparty relationships, the most practical way forward would be for the CFTC to work with European and Asian regulators to push-back the March 1 deadline to September 1, 2017, or implement a six-month phase-in period. Hopefully, with the post-election changes at the CFTC, U.S. regulators will have more flexibility to harmonize derivatives regulation than they did under the prior administration. Let’s hope that U.S. and global regulators can agree on a consistent approach. Otherwise, the March 1, 2017 VM big bang will cause March madness.